Third Time, Someone Will Believe: Manage Risk or It Manages You

Angry Bear Blog

Jan. 29, 2011, 7:05 PM

As the late Allison Snow-Jones noted, economics depends on working mathematics. Mathematics, in turn, depend on the conditions being described correctly. If I build a model in which two things are independent, they have to be independent for my model to work. Or, to quote a quoting: Many months ago, I quoted the brilliant Janet Tavakoli's book Credit Derivatives and Synthetic Structures: The trader then went on to tell me that Commercial Bank of Korea would sell credit default protection on bonds issued by the Commercial Bank of Korea. "That's very interesting," I countered, "but the credit default option is worthless." "But people are doing it," persisted the trader. "That's because they don't know what they're doing," I affirmed. "The correlation between Commercial Bank of Korea and itself is 100 percent. I would pay nothing for that credit protection. It is worthless for this purpose." The trader mustered his best grammar, chilliest tone, and most authoritative voice: "There are those who would disagree with you." (p. 85) That apparently includes the Spanish government: The Frob capital injection comes in the form of convertible preference shares from the Frob, or Spain's Fund for Orderly Bank Restructuring. As a reminder, the Frob itself has lending capacity of €15bn and can leverage itself to €99bn by issuing bonds — guaranteed by the Kingdom of Spain — to private investors. And the equity it lends to banks really resembles more of a subordinated loan than actual loss-absorbing capital. What's more, it pays a coupon and is excluded from core Tier 1 calculations under incoming Basel III rules for this very reason. Did we mention the Frob is also backed by Spain? I realise all the attention is on Egypt right now—and it should be&mdaash;but the rest of the world is going to be there on Monday, too. And traditional "sovereign risk management" still has a ways to go.